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What's Behind Gazprom's Decision to Cut Off Supply to Ukraine

Gazprom’s announcement that it would terminate gas supply to Ukraine has been a shock to many observers, but it is not as radical nor as surprising as it may seem, writes Anna Mikulska of the Center for Energy Studies at Rice University’s Baker Institute for Public Policy. It will only become effective in 2019 and is consistent with the company’s earlier announcements and long-term plans. Nevertheless, Mikulska adds, there is reason for the EU to scrutinize Gazprom’s actions closely.

On March 2nd, Gazprom announced that it would “immediately commence the procedure of terminating its gas supply and transit contracts with Naftogaz…” The move has been a direct response to the February 28th ruling by the Stockholm Arbitral Tribunal that requires Gazprom to pay over $2.5 billion for the losses that Ukraine experienced due to disadvantageous conditions of the 2009 gas contract. But while the decision may seem abrupt and unpredictable to some observers, it has been consistent with the Company’s goals and longer-term strategy.

The move is consistent with Gazprom’s long established goal to avoid Ukraine as a transit country as their contract expires in 2019

To begin, Gazprom displays many of the trappings of a commercial entity, but in practice, frequently functions as an extension of the Russian state. With ongoing presidential campaign that is focused on highlighting Russian power, it is difficult to imagine that Gazprom would quietly agree with an arbitration decision that could be seen as weakness not only on the part of company but also of Russia.

Not so immediate

Also, despite the threatening tone, Gazprom’s announcement suggests a less immediate time schedule and a more strategic approach, as the Company “immediately commences the procedure of terminating” rather than “terminates immediately” any contractual obligations that relate to supply and transit of gas via Ukraine.

As such, the move is consistent with Gazprom’s long established goal to avoid Ukraine as a transit country as their contract expires in 2019. Meanwhile, the “procedure” that is supposed to follow Gazprom’s announcement may not even conclude until 2019. In addition, Gazprom’s long-term contractual obligations with third countries, many of which expire well into 2020s, will need to be renegotiated to change their destination points from Ukraine-based flanges to hubs.

Due to considerable push from its European long-term contract partners, Gazprom was forced to renegotiate many of its long-term agreements

Those re-negotiations will also take time and, until they commence, at least some Russian gas is likely to flow via Ukrainian pipelines.

Interestingly, this relatively near-term (though not immediate) ability of Gazprom to abandon Ukraine as a transit territory hinges upon combination of EU market and policy factors.

Changing market conditions

First, global abundance of natural gas and increasing competition galvanized European gas buyers and led a number of them to pursue legal action to renegotiate long-term gas supply deals with Gazprom to obtain more favorable pricing and terms of engagement. This includes greater volumetric flexibility under Gazprom’s take-or-pay (ToP) agreements. In essence, a take-or-pay clause requires a supplier to provide a certain level of contracted gas or pay the price of the undelivered volumes. Customers are in turn obligated to accept those volumes or pay the price of the refused gas.

Gazprom is careful to maintain its reputation as a reliable supplier, particularly to Western Europe

In recent years, due to considerable push from its European long-term contract partners, Gazprom was forced to renegotiate such clauses in many of its long-term agreements with minimum delivery requirements lowered significantly—in some cases, from 85% down to only 70% of the formally contracted volume.

The reduction in commitments was hardly Gazprom’s desired course of action as it leaves some “firm revenue” on the table. However, it also potentially facilitates Gazprom’s strategy to avoid Ukrainian transit, especially when combined with the recent decision by the Court of Justice of the European Union (CJEU) to allow Gazprom to use up to the maximum capacity of the Opal pipeline (until a final ruling is announced in 2019).

The Opal pipeline is an extension that allows distribution of gas imported through the Nord Stream 1 pipeline that brings Russian gas directly to Germany and can provide a way for delivery of Russian gas that bypasses Ukraine.

While market is certainly an important factor it does not entirely determine Gazprom’s behavior and company’s prevalent commitment to the interest of the Russian state

As calculated by Simon Piraniand and Katja Yafimova of the Oxford Institute for Energy Studies, in absence of new pipelines (which is currently the case), 70% ToP levels coupled with Gazprom’s ability to use up to 100% of capacity of Opal pipeline provide necessary and sufficient conditions to ensure all but 6.6 bcm of Gazprom’s minimum necessary gas supplies to Europe can be delivered through routes that do not cross Ukrainian territory (at 2014 exports levels).

At the same time, Gazprom is careful to maintain its reputation as a reliable supplier, particularly to Western Europe. Whether or not in anticipation of the Stockholm ruling and its fallout, Gazprom provided record-high deliveries to the EU at the end of February to top gas storage in Germany, Austria and Netherlands, providing much needed assistance during an exceptionally cold winter weather.

Over the last decade or so, the growing competition on the EU market has impacted the way Gazprom operates, pushing the company to adapt to new conditions and compete for access to consumer. But while market is certainly an important factor it does not entirely determine Gazprom’s behavior and company’s prevalent commitment to the interest of the Russian state.

Minimizing negative impact

Against this backdrop, European policy makers need to devise a policy that minimizes the potentially negative impact of Gazprom’s actions that serve political objectives or are a manifestation of power.

The EU should be wary of agreements that can limit options for natural gas delivery across the region

Specifically, the EU should be wary of agreements that can limit options for natural gas delivery across the region. This includes a close scrutiny with respect to decisions on awarding pipeline capacity and investments such as the Nord Stream 2.

Continuing investment in infrastructure to help diversifying natural gas supplies is also important, particularly in countries of Central and Eastern Europe where dependence on Russian gas often remains high.

After all, the only reason Ukraine has not been exceedingly worried about Gazprom’s announcement has been its ability to immediately access European reverse flows capacity and sign a contract with the Polish natural gas supplier PGNiG for delivery of gas starting as early as March 2nd. This speaks to the value of EU’s diversification efforts, including those by Poland and the need to expand those efforts going forward.

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